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Chapter-14

Foreign Exchange Markets and

Exchange Rates

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OUTLINE

14.1 Introduction

14.2 Functions of Foreign Exchange Markets

14.3 Foreign Exchange Rate Systems

14.4 Spot and Forward Rates, Currency Swaps etc

14.5 Foreign Exchange Risks, Hedging, and Speculation

14.6 Interest Arbitrage and the Efficiency of Foreign

Exchange Markets

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14.1 Introduction

The foreign exchange market is the market in which individuals,

firms, and banks buy and sell foreign currencies or foreign exchange.

The foreign exchange market for any currency—say, the U.S.

dollar—is comprised of all the locations (such as London, Paris,

Zurich, Frankfurt, Singapore, Hong Kong, Tokyo, and New York)

where dollars are bought and sold for other currencies.

These different monetary centers are connected electronically and are

in constant contact with one another, thus forming a single

international foreign exchange market.

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14.2 Functions of Foreign Exchange Markets

1. Transfer of Funds / Purchasing Power

• Demand of foreign currency

• Supply of foreign currency

Four Levels of Participants/ Transactors

First Level- Immediate Users and Suppliers

Second level- Commercial Banks—Clearing houses

Third Level- Foreign Exchange Brokers ( so-called Interbank or Whole sale market)

Fourth Level- Central bank

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2. Credit Function

3. Facilities for Hedging and Speculation

FOREX Markets works 24 hours per day

As banks end their regular business day in San Francisco

and Los Angeles, they open in Singapore, Hong Kong,

Sydney, and Tokyo; by the time the latter banks wind down

their regular business day, banks open in London, Paris,

Zurich, Frankfurt, and Milan; and before the latter close,

New York and Chicago banks open.

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Exchange Rate Systems

Fixed / Managed Exchange Rate System

Managed Floating Exchange Rate System

Floating/Flexible Exchange rate System

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Fixed / Managed Exchange Rate System

Central Bank or Monetary Authority

State Bank of Pakistan

Revaluation or Devaluation

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Managed Floating Exchange Rate System

Example

SBP sets range for USD 100-110

Within this range USD rate is flexible but

Range is managed

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Floating / Flexible Exchange Rate System

Demand and Supply Framework

Appreciation or Depreciation

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14.3 Foreign Exchange Rates

Equilibrium Foreign Exchange Rates

R= $/ €=1

Number of dollar needed to purchase one euro

Appreciation of a Currency

Depreciation of a Currency

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Equilibrium Foreign Exchange Rates

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Arbitrage

The exchange rate between any two

currencies is kept the same in different

monetary centers by arbitrage.

This refers to the purchase of a currency in

the monetary center where it is cheaper, for

immediate resale in the monetary center

where it is more expensive, in order to make a

profit.

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Example: Two-Point Arbitrage

$0.99 = €1 in New York

€1 = $1.01 in Frankfurt

Buy…. from………… and Sell …in…..

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Example: Two-Point Arbitrage

$1 = €1.02 in Hong Kong

€0.99 = $1 in Paris

Buy…. from………… and Sell ….in…..

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Example

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Example: Three-Point Arbitrage

$1 = €0.99 in New York

€1.01 = £0.64 in Frankfurt

£0.64 = $1 in London

Cross Rates?

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Example: Three-Point Arbitrage

$1 = €1 in New York

€1 = £0.63 in Frankfurt

£0.65 = $1 in London

Cross Rates?

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14.3C The Exchange Rate and the Balance of

Payments

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14.4 Spot and Forward Rates, Currency Swaps,

Futures, and Options

Spot Transaction & Rate

Spot transaction involves the payment and

receipt of the foreign exchange within two

business days after the day the transaction is

agreed upon.

The exchange rate at which the transaction

takes place is called the spot rate.

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Forward Transaction & Rate

A forward transaction involves an agreement

today to buy or sell a specified amount of a

foreign currency at a specified future date at a

rate agreed upon today (the forward rate).

The typical forward contract is for one

month, three months, or six months

Three months the most common

Forward contracts can be renegotiated for one

or more periods when they become due.

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If the forward rate is below the present spot

rate, the foreign currency is said to be at a

forward discount (FD) with respect to the

domestic currency.

Example: if the spot rate is $1 = €1 and the

three-month forward rate is $0.99 = € 1

If the forward rate is above the present spot

rate, the foreign currency is said to be at a

forward premium (FP)

Example: if the spot rate is $1 = €1 and the

three-month forward rate is $1.01 = € 1

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14.4B Foreign Exchange Swaps

A foreign exchange swap refers to a spot sale of a

currency combined with a forward repurchase of the

same currency—as part of a single transaction.

For example, suppose that Citibank receives a $1

million payment today that it will need in three

months, but in the meantime it wants to invest this sum

in euros.

The swap rate (usually expressed on a yearly basis) is

the difference between the spot and forward rates in

the currency swap.

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14.4C Foreign Exchange Futures and Options

A foreign exchange futures is a forward contract for

standardized currency amounts and selected calendar

dates traded on an organized market (exchange).

The currencies traded are the Japanese yen, the

Canadian dollar, the British pound, the Swiss franc, the

Australian dollar, the Mexican peso, and the euro.

International Monetary Market trading is done as

contracts of standard size.

The IMM imposes a daily limit on exchange rate

fluctuations.

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The IMM Contracts details

Japanese yen contract is for \12.5 million

Canadian dollar contract is for C$100,000

Pound contract is for ￡62,500

Euro contract is for ¤125,000

Only four dates per year are available: the third

Wednesday in March, June, September, and

December

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Forward vs Future Markets

In the futures market

Only a few currencies are traded

Trades occur in standardized contracts only

Few specific delivery dates

Subject to daily limits on exchange rate fluctuations;

Trading takes place only in a few geographical

locations, such as Chicago, New York, London,

Frankfurt, and Singapore.

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Futures contracts are usually for smaller amounts than

forward contracts and thus are more useful to small

firms than to large ones but are somewhat more

expensive.

Futures contracts can also be sold at any time up until

maturity on an organized futures market, while forward

contracts cannot.

While the market for currency futures is small

compared with the forward market, it has grown very

rapidly

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A foreign exchange option is a contract giving the

purchaser the right, but not the obligation

to buy (a call option) or to sell (a put option) a standard

amount of a traded currency on a stated date (the

European option) or at any time before a stated date

(the American option) and at a stated price (the strike

or exercise price).

Foreign exchange options are in standard sizes equal to

those of futures IMM contracts.

The buyer of the option has the choice to purchase or

forego the purchase if it turns out to be unprofitable.

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The seller of the option, however, must

fulfill the contract if the buyer so desires.

The buyer pays the seller a premium (the

option price) ranging from 1 to 5 percent

of the contract’s value for this privilege

when he or she enters the contract.